Monetary System Monetary System Relationship between monetary system

Monetary System

Monetary System Ø Relationship between monetary system and foreign exchange rates Ø Historical development Ø Fixed vs floating exchange rates Ø Role of the IMF and World Bank Ø Implications for managers

International Monetary System Ø Currency exchange rates depend on the structure of the international monetary system Ø In 2003 of all IMF members currencies – Only 19% were free floating – 25% were managed float – 8% were adjustable peg – 22% were fixed peg – 4% were fixed by a currency board – 22% were not currency of their own (use Euro, US Dollar)

Evolution of the International Monetary System Ø Gold value Standard: currencies pegged to gold – Convertibility guaranteed – By 1880 most on gold standard – Balance of trade equilibrium for all countries Value of exports should equal value of imports l Flow of gold used to make up differences l – Abandoned in 1914 Failed resumption after WWI l Great Depression l

Bretton Woods (1944 - 1973) Ø 44 countries met to design a new system in 1944 Ø Established: International Monetary Fund (IMF) and World Bank – IMF: maintain order in monetary system – World Bank: promote general economic development – Fixed exchange rates pegged to the US Dollar – US Dollar pegged to gold at $35 per ounce – Countries maintained their currencies ± 1% of the fixed rate; buy/sell own currency to maintain level

The Role of the IMF Ø IMF maintained exchange rate – discipline l National governments had to manage inflation through their money supply – flexibility l Provides loans to help members states with temporary balanceof-payment deficit; – Allows time to bring down inflation – Relieves pressures to devalue l Excessive drawing from IMF funds came with IMF supervision of monetary and fiscal policies – Allowed to 10% devaluations and more with IMF approval Ø 187 members by 2003

The Role of the World Bank Ø World Bank (IBRD) role (International Bank for Reconstruction & Development) – Refinanced post-WWII reconstruction and development – Provides low-interest long term loans to developing economies Ø The International Development Agency (IDA), an arm of the bank created in 1960 – Raises funds from member states – Loans only to poorest countries – 50 year repayment at 1% per year interest

Collapse of Bretton Woods Ø Devaluation years pressures on US dollar after 20 – Lyndon Johnson policies Vietnam war financing l Welfare program financing l – Nixon ended gold convertibility of US dollar in 1971 – US dollar was devalued and dealers started speculating against it for further devaluation – Bretton Woods fixed exchange rates abandoned in January 1972

Jamaica Agreement 1976 ØFloating rates declared acceptable ØGold abandoned as reserve asset; – IMF returned gold reserves to members at current prices – Proceeds placed in trust fund to help poor nations – IMF quotas – member country contributions – increased; membership now 182 countries – Less-develop, non-oil exporting countries given more access to IMF Ø IMF continued its role of helping countries cope with macroeconomic and exchange rate problems

Case for Floating Exchange Rates – Monetary policy autonomy – Trade balance adjustments helped The Case for Fixed Exchange Rates – – Monetary discipline Speculation limited Uncertainty reduced Trade balance adjustment effects on inflation controlled Who is right?

Recent Activities and the IMF Ø Ø Ø Mexican Crisis 1995 Russian Ruble crisis 1995 Asian crisis 1997/1998 – Events l The investment boom l Excess capacity l The debt bomb l Expanding imports l The crisis Ø How does the IMF achieve results? – Inappropriate policies? – Moral Hazard? – Lack of accountability?

Managerial Implications Ø Currency management – Currency market does not always work as expected – Government intervention – Speculative activity Ø Business strategy – Movements in exchange rates are difficult to predict – Forward market is imperfect predictor of exchange rate movements – Forward exchange rate market covers risk for months not years – Maintenance of strategic flexibility required l l Disperse manufacturing Outsource – Corporate-government relations